September 04, 2009
– Comments (10)
As Klarman tells you biotech investing can be value investing.
Watch that video! And why has that post received only 2 recommendations so far? It is "one of my best" posts.
Efficient market? Not in Biotech.The central purpose of my concentration on the small-cap biotech sector is to disprove the hypothesis that the market cannot be beaten, i.e. that at any given moment the price of a stock closely reflects the weighted average of all possible outcomes for the company given all information publicly available. Needless to say, to accept this efficient market hypothesis is to render retail investing useless, as the laws of probability dictate an eventual zero sum game minus the costs of trading. I know I won’t ever be able to prove or disprove this in CAPS, since my own performance may deviate from the probabilistic mean and also because CAPS scores my picks against the S&P, a completely artificial metric. However, after two years of following the sector I am confident that in occasional circumstances the collective intelligence of all investors displays a marked disparity to a reasonable appraisal of value that would be apparent to an intelligent investor who follows the company closely. Probably the best example I have encountered of a stock being undervalued in this manner is Progenix in March of 2008. The share price dropped 60% to about 5 on news that a phase III trial of IV methylnaltrexone in post-operative ileus had negative results. Here is an excerpt from the pitch on my subsequent green thumb: “Progenix stock has tanked on what seems to be a wild overreaction to bad news of limited short-term relevance. I reviewed this company fairly closely and I didn't even know there was a phase III trial of INTRAVENOUS methylnaltrexone for post-operative ileus in progress. The short-term story for this stock is SUBCUTANEOUS methynaltrexone for opioid-induced constipation, not post-operative ileus. The whole IV methylnaltrexone for POI thing was basically a side project, not the justification for the whole enterprise value of the stock. The company is now trading at cash value, possibly below. Zero valuation of subcutaneous methylnaltrexone, zero valuation of pro140 (now in phase II). If I suck wind on this outperform, I will suck it strongly and proudly.” At that time, Progenix was already awaiting European and FDA approval for subcutaneous methylnaltrexone, a compound which had already achieved phase III success for opioid-induced constipation. Within a month both approvals were granted and the stock was over 14. My green thumb paid off 158 points, my best score to date. While those approvals were far from guaranteed, the drop in an already low-priced stock after negative phase III results in a virtually unrelated trial made no logical sense. The only conclusion I could come to was that retail investors and likely even institutions who did not understand the stock created a chain reaction of selling after somehow misinterpreting the trial results as having negative implications for FDA approval of subcutaneous methylnaltrexone. A similar event recently happened in the opposite direction. One of my earliest CAPS picks was a red thumb on a company called La Jolla Pharmaceuticals, a small company with a pipeline consisting of a single drug, Riquent for lupus. La Jolla was flying high the first half of 2007 after reporting encouraging preliminary data in their ASPEN phase III trial of Riquent. Unfortunately, this wasn’t the first time Riquent went through phase III. Years earlier, a lower dose of Riquent failed a phase III trial yet the company proceeded with an NDA anyway, which the FDA predictably rejected. Furthermore, the encouraging preliminary data from the new phase III trial was not true interim data on clinical response, but related to analysis of a surrogate marker that was not well-correlated to outcome. I felt that the company was being disingenuous both in simply repeating the long phase III trial simply with a higher dose of a failed drug, and in exaggerating the importance of an early subclinical result. After researching the history of Riquent, I came to the following conclusion in July 2007 with LJPC at 4.45: “The clock is ticking on Riquent which will fail this phase III as it did in previous trials. This is a classic example of a company clinging to a single doomed product in order to extend the careers of the board and top management. I expect "shock and disappointment" when the negative interim results are released in 2008.” In October 2008 I gave up on the pick when the share price had dropped to 1.13, writing: “Riquent and La Jolla will die in 2009, but I don't feel like waiting. If the market pops up by then I'll be leaving points on the table, but I think we could be looking at a long period of stagnation. I'm picking a nice up day, over 40 points on the red thumb. Point made.” The falling S&P had degraded the value of my successful underperform, and frankly I was just sick of looking at it on my CAPS profile. But the economy and small cap malaise continued to weigh on the share price, which eventually bottomed at 0.44 in December 2008 without any significant negative catalysts. I still updated my database on the stock, but didn’t watch the company particularly closely. In January of this year I was surprised to see news that the company had managed to license Riquent to Biomarin, a company I always thought of as being very sensibly managed. I was even more surprised to see La Jolla stock continue to spurt upward past the initial double after the partnership announcement, doubling a second time to reach a high of 2.8. Did well-informed investors really believe that the Biomarin pact changed the risk/reward ratio in the ASPEN trial so immensely as to justify a six-fold increase from recent lows? Or had an initial surge of excitement permitted a dam of pessimism to simply burst? I red thumbed as soon as I could given the 100 million market cap threshold for CAPS, stating as follows: “La Jolla bounced back on a questionable decision by Biomarin to partner up on the Riquent program, a project that is by consensus almost certainly doomed to failure. Of course, at LJ's pitiful market cap is was enough for more than a double in share price. It's a nice opportunity to replant my red thumb and collect a decent chunk of CAPS points at the latest by the end of 2009, when the topline data for the phase III trial of Riquent will be released. And this time hopefully the S&P won't drop 50% to cut my score.” I didn’t have to wait that long. The first true interim analysis of the ASPEN trial came back just a week later showing futility of trial continuation and the share price vaporized. La Jolla is finished, kaput, history. And it was the most predictable implosion I’ve seen so far. While I know this was devastating to the investors who bought at the peak at the beginning of this month, I have to wonder how many of them took advantage of the research tools easily available to them via the Internet. Clearly enough piled on for the sake of hype and momentum to degrade the collective intelligence far below that of a reasonable investor exerting due diligence. So much for efficient markets in the small cap biotech sector. Interestingly, of all my red thumbs this was the one that the most highly ranked CAPS players chose to tag along with. It’s another way that I see how the top players are truly seeing stocks at a different level, using me to locate potential plays in an unfamiliar sector but evaluating them on their own terms and outperforming me at my own game. Anyway, the point of all this post-hoc analysis is not to brag about my best calls, but to challenge myself to take advantage of those rare opportunities when a huge discrepancy between share price and true value presents itself. So far these occasions have come only about once a year, but I pledge that the next time I see one I’ll put my rep on the line for it. While plugging away at 55/45 percentages eventually wins in the long term, the only way to really beat the market is to keep some resources in reserve for those rare 90/10 opportunities and go in hard. Next time, no hesitation.
some of the best biotech/pharma/instruments calls from my list of calls as of 09/09/02 (from comment #33 here).
So don't let people separate you from your money (that is from one of my favourite camistocks quotes) by telling you how overvalued most of them are. I think they are not! And yes, the biotech stock market is not efficient.
(What is truely ironic is that someone tried to explain to me that Klarman (author of this book) did not know about how to calculate the "margin of safety". I told him to write Klarman a message. I can't link or copy that funny conversation here because the guy is easily upset when his remarks are quoted.
Klarman by the way not only told you on March 17, 2009 why you should consider buying FACT shares, his fund Baupost Group is a "major" shareholder of FACT.
09/09/02 makes sense in some parts of the world but you might be used to this format.
The paper Klarman mentions in the video (from the Tweedy, Browne research site):
What Has Worked in Investing (pdf)
Sadly Porte I only have one rec to give. I agree this is one your more readily accessible posts.
What always crack me about EMH believers is that they talk about the market's great "efficiency" as though it were a completely positive attribute. I think Klarman and Buffet would agree that a little inefficiency in pricing is a good thing. :)
did not know about how
did not know how
Yes, good old inefficient markets. I initially called my player portefeuille11 "nonefficient" and my player portefeuille7 "markethypothesis".